To find a mystical 10-bagger you must ignore all the froth

By Luke Johnson

12:01AM BST 07 Aug 2005

One of the best books of modern times about investing was published in 1989 and is called One Up On Wall Street. It was written by a clever fund manager at Fidelity, Peter Lynch, and it introduced me to the concept of "10-baggers", the Holy Grail of investing.

Ten-baggers are shares where you make 10 times your money (I believe the phrase is derived from baseball). Such opportunities are rare, but I have been fortunate enough over the past 15 years to be involved in a few such situations: Pizza Express, Topps Tiles and Abacus Recruitment among them.

There tend to be some common characteristics among these winners. The businesses all operate in growth industries and the company in question must be able to grow the top line. No one ever made a tenfold return on a pure margin improvement, or cost-cutting story with no sales growth.

Turnarounds are, however, a rich source of 10-baggers. For these to work, one's timing has to be immaculate, and the underlying business has to be sound - just desperately unloved by the stock market.

Those two retail recovery stories, Next and French Connection, come to mind: both have been 10-baggers for those who bought at the bottom in the early 1990s. Recessions and downturns will occasionally reveal such gems, decent firms with temporary problems which can be cured.

Such returns need patience. A hedge fund that churns its holdings every few months will never enjoy a 10-bagger. And therein lies the greatest danger: selling too early to enjoy the 1,000 per cent gain.

When you have doubled or trebled your money, it is so tempting to cash in profits. It must have been tempting in the early 1950s to take profits on Glaxo shares, just a few years after their 1947 flotation. Or to have done the same for Tesco which floated in the same year. Or sell Racal in the late 1960s after its 1961 market debut, decades before it spun off Vodafone. Yet each of those shares rewarded patient investors with epic performances over many decades, all 20-baggers at least, not even allowing for dividend.

One of the advantages that private equity enjoys is that it is forced to take a reasonably long-term view, and so is usually unable to rush for the exit at the first opportunity. Venture capital's other edge over quoted investors is debt: gearing in successful situations always amplifies the return to equity-holders. Typically, buy-outs have structures where 70 per cent of the capital is borrowed.

Quoted companies probably have the reverse capitalisation, with equity providing three-quarters of the funding. And as ever in investing, those who regularly find 10-baggers say you should stick to your own sphere of competence: buy what you understand.

A good source of 10-baggers has been privatisations. Of the 43 public-sector companies floated in London, at least four have returned more than 10 times their issue price: Associated British Ports, Amersham, BP and Forth Ports. Proof, I suppose, that governments tend to sell state assets cheaply, or perhaps that such organisations thrive in private ownership.

While the UK has few such businesses left to flog off, there are a number of countries such as France and Turkey that have active privatisation programmes where there might just be 10-baggers waiting to be discovered.

Indeed the UK is a mature economy and therefore finding new sectors - and stocks - experiencing sustained, rapid growth is harder than ever.

It may well be that the most exciting investments are in emerging economies which are expanding quickly. Luckily capital markets like Aim are attracting dozens of foreign companies looking to raise money, so British investors do not necessarily need to buy shares quoted on overseas exchanges. But the usual rules apply: look for real companies with competent management and a proven business model.

You won't find a 10-bagger among much of the over-hyped, speculative froth that comes to Aim. Search for the solid operation with strong fundamentals and a high quality of earnings.

Very few acquisitive vehicles are 10-baggers. Management in such firms focuses on doing deals rather than organically growing its core business. This can produce reasonable returns, but rarely delivers the stellar, long-run performance that can come from a strong business franchise in an attractive niche. And balance sheets matter: 10-baggers must be able to fund expansion internally or through debt. Companies that are forever issuing equity dilute their stock performance.

So good luck in your search for the next blockbuster. It may well be an obscure, neglected company now, but with the potential for greatness. The secret is to spot that potential.